Properties of the Margrabe Best-of-Two Strategy to Tactical Asset Allocation
International Review of Financial Analysis, Forthcoming
26 Pages Posted: 6 Dec 2017 Last revised: 31 Dec 2018
Date Written: November 30, 2017
The Margrabe Best-of-two (MBo2) strategy is a rule-based dynamic investment solution for the two-asset allocation problem. Its typical implementation involves yearly rebalancing the portfolio weights to 50-50 between a high-risk and low-risk asset. It uses intra-year weight adjustments to chase the momentum of the best performing asset by replicating the value of a Margrabe option to exchange an asset for another asset. In practice, this means that the Margrabe portfolio allocation benefits from the upside potential of the high-risk asset and the downside protection from the low-risk asset. The MBo2 allocation depends on the assets' prices, their return volatilities and correlation, as well as the remaining time until year-end. In this paper, we derive analytical formulae and use simulations to provide insights on the sensitivity of the strategy's weights and performance to these input parameters. We also report the results of an extensive out-of-sample evaluation for the bond-equity investment problem.
Keywords: Best-of-Two, Bond-Equity, Margrabe, Tactical Asset Allocation, Upside Potential, Downside Protection
JEL Classification: G11
Suggested Citation: Suggested Citation